Josh Brown recently
wrote a blog post highlighting what Mohamed El-Erian said at the PIMCO
Investment Conference. Since my
invitation got lost in the mail, I had to settle for reading his summary, which
was quite good.
Like
Mr. Brown, I think that Mohamed El-Erian is not only a great macro thinker, but
communicates his/PIMCO’s views as clear as anyone. Further, their track record has been
extremely solid since before the financial crisis despite the occasional
misstep. I doubt you could find much
better.
Three
things really struck me. For ease, the
big bullets are Josh’s notes along with El-Erian’s quotes. The highlights are mine to add emphasis. My comments are in italics under their
respective bullets.
- Risk management: People used to think that diversification was good enough, but no more. "Diversification is necessary for any investor but it is not sufficient when central banks have distorted prices." He says the way to think about insuring tail risk is the same as you would car insurance. You maintain it at all times, not try to guess when you'll need it. He is talking about far-out-of-the-money options that hedge against unforeseeable outlier events, which is what his fund does.
- I totally agree that diversification is no longer adequate to control risk, given how correlations move to 1 and -1 in times of stress. Tail risk insurance, using momentum to move risk on/off, and/or stop-losses at waterlines are good ways to contain risk. Diversification only manages to moderate risk. That is an important distinction.
- Beta heavy lifting: He thinks the beta heavy lifting is probably over in asset markets. In bonds, he says the capital appreciation returns from treasuries, corporates and high yield bonds are done too. Lastly, someone asked him a Vanguard-related passive indexing question. Mohammed tells a killer anecdote from early in his career about how EM bond indexes were once made up of 22% Argentinian bonds pre-default, and that the other managers who were hugging that index got hammered. He says that passive makes sense only if you'll be driving in reverse up a road that is completely straight. Because you're essentially looking at snapshot of the way things were.
- Passive is less preferable to active in this environment. Again, I think he is spot on here, though PIMCO would have this view given they are an active shop. This is especially true on the Fixed Income side. I will say the caveat is finding the right active managers, which is more of a qualitative function and can prove to be difficult.
- Central Bank Brand Management: He says basically a brand is like a wedge you can shove in between fundamentals of your company or product and raise prices. But that brand wedge is finite and cannot keep things apart or elevated indefinitely, there is a limit to what a brand can do… Central banks are also a brand. The brand is "we can deliver outcomes today to improve the future." Right now people believe in the central bank brand, watch out for when that belief in the brand turns. Right now the psychology about the Fed's brand is positive, "but psychology goes both ways."
- What if Central Bank psychology in regard to the market reverses? Admittedly this is something I need to look into more. He elaborated more on that thought recently. His basic point is that even powerful brands can only continue for so long until fundamentals justify (or on the negative side, no longer justify) the price (e.g. he mentions APPL). In this specific instance, it’s that central bankers are hoping that in increase in financial market prices will filter down to the real economy. El-Erian is skeptical this will work, and notes risks about the unintended consequences. He wonders what happens if investors no longer believe the fundamentals justify the financial market prices, even if central bankers continue their current policies. All of these are legit concerns; however, in my opinion they are all fixable.
